Understanding the low interest rate era

You probably don’t need me to tell you that interest rates are very low right now. In fact, interest rates are around 5,000-year lows:

Even the ancient Mesopotamians didn’t enjoy the low interest rates we see today.

That graph was devised by Andy Haldane, chief economist at the Bank of England, and circulated in October 2015. Since then both the red and blue lines have dived even closer towards (or in some countries below) the 0% flat line.

Such extremely low interest rates across the developed world are due to a number of factors, most directly the near-zero benchmark rates set by central banks.

In August the Bank of England cut its Bank Rate to just 0.25% in response to the UK’s vote to Brexit. An unimaginably low rate got even lower.

Central bank policy plays a huge role in setting wider interest rates by influencing what’s called the yield curve – strictly a representation of the yield you’ll get for holding bonds of lengthening maturities, but often applied to the returns from other asset classes, too.

You can see a central bank’s influence in the lower interest rates on mortgages, savings bonds, and even Santander’s popular 1-2-3 account that followed in the days and weeks after the Bank of England’s cut.

But the Bank of England had its reasons for further cutting rates, of course, and for having held its rate so low for so long in the first place.

And these reasons give us a clue as to some of the fundamental drivers of today’s very low interest rates.

The interest rate merry-go-round

This is not a Phd thesis on rates, so I will have to be necessarily brief.

Indeed I am writing this article at the request of a few readers who have asked for a super-straightforward summary of the problems potentially caused by low interest rates.

I don’t want to go off into the weeds!

So with a bird’s eye view, other factors that influence the market interest rates that we as consumers and businesses see (and that feedback into the benchmark rate-setting of central banks) include the state of the economy, inflation and deflation, currency moves, what other countries’ central banks are doing, demographics, and – I’d argue – the emotional state of savers, borrowers, and investors, and the impact of such emotions on asset prices.

There are also more contemporary or controversial causes of low interest rates. These might currently include globalization pulling down wages worldwide and boosting the supply of global savings, or the rise of robot workers. However these factors still manifest themselves as, say, deflation or as low government bond yields.

In fact all these factors interact with each other.

For instance, the economy may take a hit, confidence falter, the stock market plunge, and demand by borrowers for credit slump. A central bank might then cut interest rates to try to stimulate the economy by making money cheaper, and so encourage more borrowing.

Similarly, when the economy is very strong, investors are going crazy, borrowing is at all-time highs, and the central bank fears excess demand could provoke inflation, it might raise its benchmark rate to try to dampen all those factors.

By raising and lowering interest rates like this, the central bank is aiming to dampen the extremes of the economic cycle.

A key thing to remember though is that central banks do not set market interest rates; rather their own reference rate and any associated monetary operations influence market rates, and are influenced by them.

The great rate debate

So how do we square those dynamics with today’s economic picture?

Bank Rate in the UK is at an all-time low, yet few would say the economy is the worst it’s ever been, or investors at their most depressed.

People have been arguing about near-zero interest rates ever since the financial crisis ushered them in for the UK, the US, and Europe (with Japan having had very low interest rates long before then).

Central banks initially slashed rates in direct response to the value destruction of the financial crisis, which wiped trillions off asset prices and caused a surge in unemployment and fearfulness that threatened to submerge the world in an economic depression.

Supporters of the extremely low interest rate strategy – and its bedfellow, quantitative easing – claim lackluster economic growth and the absence of high inflation since the near-zero rate era began shows that continuing with such low rates has been appropriate, that things would have been much worse without them, and that fears of an inflationary spiral have proven groundless.

Critics respond with three main lines of attack.

Firstly, they say inflationhas been caused by low interest rates, only it’s shown up in asset prices rather than in shopping baskets, with the price of everything from bonds, shares, and property to art and collectibles soaring.

Secondly, they argue a broader inflationary shock has been stored up for the future. It’s like shaking a ketchup bottle, where nothing comes for ages and then it all splurges out at once. Just wait, they say.

Thirdly, many contend near-zero interest rates may have become part of the problem, rather than the solution.

The theory here is that because there’s little penalty now for being a poorly run and indebted business – because you can limp along thanks to cheap financing – low interest rates may be gumming up efficiency and productivity growth, and inhibiting the creative destruction that enables superior companies to grow at the expense of their weaker rivals.

In addition, we might ask what kind of a signal do super low interest rates really send?

If your doctor told you after a heart operation that you needed to trundle around with a bleeping heart monitor next to you all day, you may well feel more nervous – even if the pattern of bleeping suggested you were actually returning to health.

Perhaps something similar is happening in our minds due to seeing low interest rates for years on end? We’re told things are improving, but maybe we’re skeptical because of the low rates themselves, and so we don’t borrow and spend as much as theory would predict.

If that’s true then low rates could actually be dampening the economy rather than helping spark it into life.

There are other potential downsides to very low interest rates, such as if they encourage people to chase higher returns through unsuitable investments.

But then that is partly what central banks are trying to achieve – by trying to get crisis-scarred savers out of cash and into more productive assets, others out of bonds and into equities, and so on.

To an extent it’s not a flaw so much as a feature.

Right and wrong

These debates have been swirling for years in the business media and among sophisticated investors.

For example, CNBC’s recent Delivering Alpha conference was pretty much a procession of hedge fund managers saying a bond and equity crash was imminent because of all the problems caused by low interest rates.

Such comments are also voiced beneath almost any article we publish on Monevator that’s to do with bonds or cash.

And newsletters and rent-a-doomster media pundits have been warning of an imminent market implosion or inflationary shock for years.

I understand where such sentiments come from. The rally that has sent the yields on trillions of dollars worth of government bonds into value-destroying negative territory is hard to square with good financial governance, or even a nodding acquaintance with economic reality.

Yet you have to remember most such warnings have proven wide of the mark for years.

In reality, inflation has stayed low, bond and equity prices have continued to rise, and the UK and US economies have grown and seen unemployment steadily fall (albeit with little in the way of wage or productivity growth).

Yet in spite of such progress, many hedge funds have delivered lousy returns since the financial crisis. One reason is they were too timid because of their disquiet at the low interest rate policy of central banks.

I’m not immune to this. While I spend much of my time warning passive investors in our comments not to suddenly start thinking they’re fortune tellers and dumping all their bonds and whatnot, I’ve had my own hunches.

I thought quantitative easing would cause inflation, and so far it hasn’t. I suspected interest rates would fall back in 2008, but I never thought they’d still be so low eight years later. I also thought bonds were finally topping out in 2015, and was wrong. (Worse, I’d had doubts years before that).

None of which is to say the dire warnings won’t eventually come true.

Markets always crash eventually, that’s nailed-on – it’s the timing that’s difficult – and I also think it’s very hard to believe that a growing global population on a finite planet will never see inflation again, even with all those robots doing jobs at slave labour rates.

But I would add that nearly ten years of seeing doomsters confounded should, at the least, be a reminder to the rest of us to stay humble and avoid hubris.

Everyone has been wrong about this stuff for years.

The optimists thought the economy would respond more quickly to low interest rates and that rates would be back to more normal levels by now.

The pessimists predicted we’d be using a wheelbarrow to take our shopping money to Tesco.

I think pragmatic investors who admitted they didn’t know how things would pan out and so stuck to their plans – and their diversified multi-asset portfolios – have carried the day on points.

Sure, they were never going to make the headlines.

But they’ve quietly achieved good gains, suffered lower levels of angst, and had less need to wipe egg off their faces every six months.

Is the tide turning for the low interest rate strategy?

The readers who suggested this as an article topic said they hadn’t seen much comment about the downsides of low interest rates.

I presume they’ve only been reading personal finance blogs and otherwise getting on with their life (and I applaud them for it) because I have read literally hundreds of thousands of words on the subject over the past few years.

I’m tempted to do a bit of post-crisis doomster bingo (hot words and phrases including the likes of manipulation, confiscation, helicopter money, Fiat currencies, ZIRP, the monetary laboratory, John Law, and gold, gold, gold) but I want to keep things simple and succinct, to honour that reader request.

So having set the scene as to why we have low interest rates, next week we’ll consider what specific potential problems such low rates may be causing that we as armchair investors need to worry about.

After all, there seem to be increasing signs that even central bankers fear we’re running out of road when it comes to very low rates.

The politicians who have hitherto been happy to let central banks carry the load are also showing signs of changing their tune.

“While monetary policy – with super-low interest rates and quantitative easing – provided the necessary emergency medicine after the financial crash, we have to acknowledge there have been some bad side effects.

People with assets have got richer. People without them have suffered. People with mortgages have found their debts cheaper. People with savings have found themselves poorer.

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“Central banks initially slashed rates in direct response to the value destruction of the financial crisis”

Which is ironic as nothing destroys value like underpriced capital. Just as it was the Fed dropping rates in response to the 1999/2000 crash that laid the seeds for the explosion of the sub prime bubble less than a decade later, so it is that the emergency basement level rates we’ve had for the last 8 years have laid the seeds for the next crash.

Trying to solve a debt fuelled problem by encouraging even more debt through low interest rates is like trying to cure an alcoholic by plying them with free booze.

Oh and Theresa May can think what she likes about monetary policy, but unless she wants to go down the road of undermining of removing completely the independence of the Bank of England, she is in no position to be determining what happens to interest rates or QE. I would suggest even the merest hint of going down that road has been partly why sterling has been so weak this week.

Good read. I must admit I am getting very itchy on my INXG and VGOV bond holdings, how much further can they go! I hold them to balance the equity part of my portfolio but the old return free risk comment keeps coming back to me. How much protection can they really offer, and is it worth the potential of a fall in value at some point when rates return to usual.

Interest rates have been too low for far too long without having the desired effect. As a result many ordinary savers have lost out or have been forced to take on more risk than they feel comfortable taking.

Lowering interest rates and increasing QE is not helping and Theresa May is right to be highlighting the plight of ordinary savers. I am sure Mark Carney is no fool and will soon be ‘on the same page’ as our PM – interest rate rises will not be long coming imho.

Thanks for the thoughts all. On the efficacy of low interest rates, I think critics are too harsh.

Let’s not forget we had the biggest financial contraction since at least World War 2, and we followed it up with a bout of austerity, which while not as austere (on the top-line) as some have suggested still represented a big fiscal contraction.

Despite this less than a decade later we were (pre-Brexit) enjoying c.2% economic growth, we’d avoided a housing crash and mass unemployment — indeed UK employment is at an all-time high.

I’m not saying rates should stay low forever or that there haven’t been downsides — I can see both sides, and I think the BOE is going to be in a tough position in making its decisions against rising inflation. But I think people are too quick to dismiss what *was* achieved by radical central bank action. Perfect, absolutely not. Problems, certainly. But pros and cons.

Regarding May and BOE independence, my view is that she’s probably not setting the scene for BOE intervention, but rather for some sort of fiscal spending boost.

Arguably (because all this is arguable! 🙂 ) if the government turns up the spending spigots then the BOE won’t have to take strain via extreme monetary policy, and at the very least can avoid doing more QE etc, and hopefully at some point sooner be in a position to begin winding it down and slowly normalizing rates.

Final salary pensions (and the implied deficits) are also worth talking about. They are compelled to buy safe bonds to match their liabilities. These safe bond in fact now look risky and have next to no yield either. Worse the liability is harder and harder to match with the yield so implying enormous deficits that have to be filled, so loading up on more and more of the same bonds that look risky and yield nothing.

The BHS pension is a case study in what happens when an open ended liability is lamped onto a clever owner – he transfers it to the tax payer 🙂 Which you could argue is where it belongs because the BoE implemented policy that made the final salary pension simply uneconomic and the BoE is accountable to parliament and hence the people the tax payer elected.

Is Carney therefore responsible for finally killing final salary pensions? It’s easy to argue a case that he played a big part.

Excellent post. A really good read.
I’d not heard that quote from the PM. She doesn’t seem afraid to take on a tough task though. As much as business and borrowers i.e. most people, will whine at the cost of a rate increase, the PM may be able to provide the stimulus to change this abnormal status quo (someone has to sooner or later and shoulder the complaining).

People are always talking about how over-valued the stock market is. But what a lot of people tend not to realize is that the low interest rates of today increase the present value of future company earnings. So while P/E ratios are high, it makes sense in the context of the current interest rate environment.

Thanks for the insightful post. As a Canadian, it’s been interesting to see Mark Carney’s approach to his role over the pond.

QE drives bond yields down, as does reducing interest rates, final Salary pensions have to buy bonds because the their liabilities are long term and predictable, just like bonds. In the private sector a final salary pension is a liability for individual companies. If the liability requires escalating capital injections to match then it is the fiduciary duty of a companies management to the shareholders that the pension be closed and as much possible the liability be quantified and limited

The Bank of England has both dropped interest rates and introduce QE (in my estimation when they didn’t need to) and Carney is it’s governor and has been an enthusiastic proponent.

I suspect we’ll not agree you believe Carney has been good, I think he’s been abject and I would point at his record since he’s been here to support that stand (and as explained above it can be strongly argued he’s played a part in the destruction of the defined benefit pension).

@Martyn –- I am not disagreeing about the impact of low rates and QE; on the contrary as I said in my earlier comment I’ll be citing the impact on pensions in part two. We agree low rates have hit pensions. What we disagree about is that it’s all/mostly Carney’s fault.

As I said in my piece, the BOE responds to various economic factors and market interest rates in setting its own rates. Carney didn’t just get out of bed on the wrong side and decide to crash rates and rout defined benefit pension schemes. He’s been operating in a global context, and faced with big challenges such as austerity in the face of a slow economy and so forth.

I don’t think Carney was great on forward guidance. But nobody covered themselves in glory with that, either here or in the US. Otherwise I like his approach and say his cut in interest rates as a response to the Brexit vote (in isolation… I think as I said there’s an argument that rates around the world have now been low enough for long enough, but Brexit was a big shock and warranted a response).

Carney allowed politics to cloud judgement, we are not paying him for that.

On a related note what happens if interest rate climb? Final Salary pension schemes closed or otherwise have bought huge amoungt of bonds at low yield. One of the things that’s nice about fixed interest is it’s relatively easy to value. If yields on new issues rise the market value of the issued bonds will fall. Sure if they bought at face value and intend to hold to redemption then the losses will be notional, but book value will drop and if forced to sell on the market then losses will be very real.

May is in a perfect position to do the hard things. She can blame it on Brexit. So the politics can almost take a back seat (i know it is not that simple). It reminds me of when Dave Lewis took over at Tesco. He basically had free reign for a couple of years to trash the company results and do all the hard things his predecessor couldn’t do due to market expectations. He could then take all the credit as the company returns to health. That’s not to belittle what he has done at all, but if everyone accepts things are going to get worse before they get better you can actually do the hard and painful things no one else wanted to do.

@All — Here’s a link to an interesting new article explaining why *real* rates have fallen, and are likely to stay low:

Probably the most important long-term determinant of the interest rate is just the pace of economic growth. Interest payments are a claim on tomorrow’s economic output. If that output grows quickly, rates will tend to be high. But there are several forces pushing down growth in our modern world. Lower growth means lower rates, even without any central bank action.

One force holding back the economy is slower productivity growth. Education levels are increasing much more slowly than they used to, and some economists argue that technology is improving at a permanently slower rate. Another factor is gender — women in developed countries have mostly entered the workforce by now, so that boost is over.

But the most powerful force is probably just aging. Developed countries are have gotten much older, and with fertility rates below replacement, most continue to do so. […]

…fears of bubbles, financial instability and excessive risk-taking are likely exaggerated. The world’s economies want lower rates all on their own. The Federal Reserve and other central banks aren’t creating much of a distortion.

Hmm, methinks that Bloomberg opinion piece may have confused cause and effect.

What if, instead of central bankers’ decisions on interest rates merely reflecting the broader demographic and productivity factors in the wider economy, it is the very act of them pushing interest rates down to rock bottom levels and then throwing QE on top that is causing the problems of misplaced investment, asset bubbles and distortions in the price signalling mechanisms that are (or should be) the bedrock of capitalism?

The suggestion that technology improving at a permanently slower rate may be causing low interest rates is risible. It reminded me of that American chap who reputedly said in 1900 “Everything that can be invented has been invented”.

“People with mortgages have found their debts cheaper. People with savings have found themselves poorer.”
Is it really the case? Without inflation or with deflation the value of the debt will stay constant or grow. Inflation “helps” who has debts eroding the value of the debt… Suppose I contracted a debt of £50000 in 1980: ten years after the present value of those 50k would be way lower (decreasing by 5% per year… without doing nothing). Not to consider that if the value of my salary growth with inflation and the value of the asset I bought growth as well… the “weight” of the debt would be even smaller.
Check for example Krugman: “Low inflation also makes it harder to pay down debt, worsening the private-sector debt troubles that are a main reason overall demand is too low.” – http://www.nytimes.com/2013/05/03/opinion/krugman-not-enough-inflation.html

I must say I am having a bit of a dilemma as no where seems safe at the moment. I have some cash for home improvements I plan in the next 2 years or so. Traditionally I would see over this time period cash is the safest place. But no interest and inflation with Brexit and QE is really starting to worry me. But where else do I put it? Everything else looks bubbly or risky in that timeframe. Maybe I should just try and move the improvements forward and spend it! Maybe that is what they want me to do 🙂

“People with assets have got richer. People without them have suffered. People with mortgages have found their debts cheaper. People with savings have found themselves poorer.”

This statement is in conflict with itself.

How can people with assets have it better while at the same time people with savings find themselves poorer? Similarly, how can people without assets have it worse, while at the same time those in debt (mortgage) benefit by finding their debts cheaper?

I’m ok with saying it’s a mixed bag, but at least define the problem better. Those with assets cannot both be simultaneously worse and better off. Similarly, those without cannot be simultaneously worse and better off.

Absolutely the official inflation figures are being massaged on a huge scale at the moment, they don’t represent the total picture of what the ordinary person faces in everyday life. If QE were to double the amount of money in play, even if that doesn’t circulate, but inflates the property bubble, (to give just one example) house prices constantly go up, as do rents.

So if those major claims on salary increase by 5% annually while real wage increases are stagnant, (surplus labour pools keep it flat for most professions) then people are getting poorer fast. They may not understand it, but they feel it, they just know they have less disposable income in their pockets at the end of the month even if a big deal is made of food prices being down slightly in the supermarket.

When house prices are inflated, monthly mortgage payments or rents have to rise to match the maths, this is thinly-veiled inflation, as are stealth taxes like increasing taxes on insurance products that just show up on bills as above inflation annual increases as opposed to a clear tax increase. (How many people scrutinise a boring insurance bill to notice a 7% increase in the bottom line?) It’s this suspicion of silent, slow impoverishment that’s feeding into the increasingly angry, populist politics in the developed countries, a deep unease at the feeling that something is going on and it’s only hurting ordinary people.

@FI Warrior – yes, and this harks back to the young people getting poorer thread. Those who own a home they can live in for ever basically have fixed payments (so even if wages only go up by 0.5% their morgatage payments don’t). At least until interest rates start going back up again but then hopefully wage increases will accelarate as well. So the owners rate of inflation is more aligned to the headline rate reported (maybe even better if they are a pensioner). The renter has to watch their rents jump up and the chance to own ever vanish off over the horizon (unless they manage to get good pay rises or have a high paying job). There rate of inflation, as you say, is much higher than what is reported!

I personally think that the low interest rates were the right move to get us out of the great recession, but that they’re still used as a tool is a mistake. It’s artificially driving up the stock market (there are a lot fewer alternative investments that will pay a rate of return) that people seem to think will go up forever but nothing goes up forever. I also think that when a recession hits (and again, low interest rates will not keep this away forever), you’ll end up with less opportunity for the central banks to help smooth it out and pull the economy out sooner.

In essence, the current low rate policy seems to be good for the present time, but it’s coming at a huge risk for the future that I don’t think is worth it.

It looks like the good times are over for bonds in the short run. Hopefully this doesn’t mean a multi year declined and bonds and a costly rising interest-rate environment. I would be bad for consumption, investment, and the real estate and bond market.

I’m presuming this is your auto-predict text speaking, otherwise those references have gone right over my head! 🙂

I think it’s extremely likely we’ve seen the bottom for bond yields. Beyond that, who knows? We were all fearing auto-deflation from demographics and robots three months ago. But yields are still pretty low by historical standards, so I could see another 1% or so on 10-years without it portending a further huge rout, maybe?